About that sovereign debt restructuring sweetener. . .

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Ben Heller and Pijus Virketis are portfolio managers at HBK Capital Management.

Lee Buchheit and Gregory Makoff have suggested accelerated sovereign debt repayment as a superior and sweeter alternative to the various “upside instruments” – warrants and macro-linked bonds – used in many recent debt restructurings, with mixed success.

It’s a good idea, and we’ve actually looked at similar mechanisms in previous restructurings. But we want to point out an important one extension of the idea, as well as an important one prescription.

The extension is to combine early payment with a concept of corporate restructuring that has so far been completely absent from sovereign practice: non-assumption.

Debt is not an alien spaceship that one day crash-lands on the front lawn of the Treasury Department. Most countries are in trouble after many years of irresponsible policies and serial borrowing. When lenders offer debt forgiveness or late payments, they face the perverse prospect of catalyzing a recovery, which allows even bigger issuance to resume!

Non-assumption covenants would prevent such behavior until the claims of existing creditors are at least partially taken into account.

Similarly, one of the main assumptions of stabilization programs concerns when and under what conditions “market access” could be restored. In reality, regained market access may come sooner and more abundantly than anticipated in the IMF program. If an issuer takes advantage of this, it’s another way lenders would be leaving money on the table and, worse, could now be exposed to greater credit risk.

One way to operationalize the “debt brake” is to do what Buchheit and Makoff suggest: to stipulate in the terms of the restructured debt that if a country can place new obligations beyond a benchmark amount, it must use the excess to service old debt first, reaping all the benefits their Alphaville post presents.

That being said, sweetness doesn’t have to go to our heads. The reality is that many times the acceleration of cash flows simply cannot defeat the restoration of at least part of the creditor’s claim. This is due to the interaction of two factors.

First, the IMF’s debt sustainability analysis could call for significant debt relief when there is substantial uncertainty about the future path of the economy. If things go well, simply accelerating cash flows may not return enough net present value to lenders to offset the loss, especially since the IMF typically sets a firm payout package for the first five or even 10 years.

Second, the prevailing level of EM bond yields may be outside an “optimal zone,” where the NPV impact of cash flow acceleration is maximized. Unfortunately, yields are quite high today, so rearranging payments with steep long-term discounts (eg from 20-year to 10-year maturity) will restore a reduced NPV.

As we were part of the creditors’ committee for the Sri Lankan debt negotiations, we will use the agreement announced on 3 July to illustrate the limitations that using prepayment alone as a value recovery tool can have when the NPV adjustments are expected to be substantial .

Below are the stylized cash flows and NPVs embedded in the base case and the largest contingent growth cases. We then ask the question that Buchheit and Makoff’s idea naturally raises: if we wanted to match the NPV of the agreed positive case, how much of the principal cash flows would we need to accelerate from the longest scheduled maturity to the shortest is the payment date still acceptable to the IMF?

As it turns out, a lot – 83 percent!

Why? Because this particular transaction (like most current restructuring transactions) does not have an extremely long final maturity, while the IMF program and post-program window stretches quite a bit. The result is that even with a fairly high exit yield, the increase in NPV from accelerating the final payback is low because the acceleration amounts to only four years.

The latest wave of sovereign debt restructuring should make it clear to everyone that it is difficult to find a once-and-for-all cash flow adjustment that can satisfy everyone. However, the market has also learned that it must design instruments and contingent features very carefully, as demonstrated by the examples of reverse value recovery instruments in Argentina and Ukraine.

Accelerating cash flows and mandatory prepayments can work as a very safe way to return value to creditors if the IMF’s debt restructuring parameters turn out to be far too conservative.

It would work particularly well when most of the lending concession comes in the form of extending low-coupon maturities. It could work in even more situations if the IMF allowed additional cash flow in program and post-program windows when a country is doing much better than feared.

However, some situations generate too much permanent relief (ie large haircuts) and too much forecast uncertainty relative to the prevailing interest rate environment to adequately reward lenders for strong performance.

The market should embrace both prepayment approaches as a form of value recovery and as a way to prevent countries from returning directly to a debt crisis – but not to the exclusion of continuing work to improve other forms of capital-like contingent own. instruments.